Over the past several years, as investors have become a bit more risk conscious and markets have gotten a bit more volatile, there have been products developed to help Main Street investors deal with the changing environment.
Investors looking to get away from the traditional sector or industry ETFs now have a bit more optionality. ETFs that do far more than track a specific sector, but instead, employ entirely different strategies that may be more sophisticated than the average investor can execute on.
Instead, large private equity companies and other institutional investment firms have created products that allow the investor to implement these complex strategies, that are often very successful, into their own personal portfolios.
The best thing about these investment products is that they are far cheaper than having your own investment advisor. The advent of the ETF has allowed the everyday investor to hitch a ride on the strategies that are so lucrative for the big boys, but without the price tags.
A not so common example of one such ETF strategy is known as the multi-factor ETF, which first appeared in 2003. As a relatively new addition to the ETF pool of products, many investors may not know full well what strategy this balanced ETF grants them access to incorporating into their portfolio.
Today, we plan to take even the most beginner of investors through a crash course on what these products can offer them. After, you should have a good enough understanding of what a multi-factor ETF to be in a place where you can determine whether or not this is right for you and your portfolio.
What Are Multi-Factor ETFs?
Multi-factor funds provide exposure to stocks with different characteristics—or factors—such as value and momentum, all in the same product. These ETFs take a broad index and apply a rules-based quantitative process to select stocks based on the chosen factors.
These funds are part of the concept of “smart beta”, which involves building portfolios skewed to factors that have historically been correlated with outperformance (1). These smart beta ETFs include value, dividend generation, momentum, small size, quality, profitability and low volatility.
Much academic research has been done regarding these “factors”.
A landmark 1992 study, by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French, argued that – based on history – focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return (3). Subsequent research conducted by University of Rochester Professor Robert Novy-Marx identified profitability as another factor that enhances expected returns.
The beauty of multi-factor ETFs is that they combine two or more of these elements. This multi-factor investing approach is designed to increase diversification and provide a smoother ride for long-term investors since it sits between passive and active strategies (2).
Take a Vanguard Multifactor ETF as a common example. The stated goal of this fund is to…
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